Portfolios track a new wave of indexes that emulate approaches used by active fund managers

Exchange-traded funds have a new weapon in their fight against actively managed stock mutual funds. It’s the strategy-based ETF.

Russell Investments is one of several investment firms now offering strategy-based ETFs. According to Mark Roberts, head of research at Russell Investments, the company’s Investment Discipline ETFs are an attempt to evaluate what an active manager might consider when selecting stocks, without the human weaknesses that can influence trading decisions, like favoritism or style drift.

Offered predominantly by Russell Investments, Guggenheim Partners LLC, Invesco Ltd. and WisdomTree Investments Inc. strategy-based index ETFs require investors to pay attention to how stocks in the index are chosen, what the strategy is, how the index is maintained and its expected performance.

Here are key questions that potential investors should ask:

What is the strategy?

The first strategy-based ETFs were designed to identify promising high-dividend stocks or to incorporate technical analysis in their methodologies, such as by favoring the stocks in an index that have been advancing most strongly. More recently, Russell Investments and QuantShares, a group of funds from Boston-based investment advisers FFCM LLC, have homed in on other measures including the volatility of an individual stock in relation to the market, and what constitutes growth or value stocks.

For example, Russell Equity Income is based on an index targeting stocks in the Russell 1000 Index that have paid or are expected to pay a dividend. The index excludes stocks with very volatile earnings, low return on equity or negative earnings forecasts. While the strategy sounds reasonable, the fund holds more than 250 stocks and has yet to differentiate itself from other large-cap value ETFs and funds.

Like all index-based ETFs, the strategy of the index will be detailed on the product fact sheet, prospectus and reports. The rules and standards of the index will either be linked to by the ETF provider or available from the index firm. In some cases, as with this Russell product, the index provider may be an affiliate of the ETF sponsor. If investors think that is too cozy a relationship, they may want to see if another ETF and/or index provider offers a similar strategy.

How does this strategy fit into my portfolio?

Strategy-based ETFs can be a tough fit for traditional index investors or advisers who use index-based ETFs to construct portfolios. These ETFs are largely geared to attract investors who prefer the styles and theories espoused by many active managers, but without the whims of human decisions.

How much to allocate to a strategy-based ETF depends on your own investment style. If you believe share buybacks are an indicator of corporate strength, you might consider PowerShares Buyback Achievers. The $58 million ETF, which has outperformed the average fund in Morningstar’s large-blend category over the past three years, is based on an index from Mergent Inc. that tracks companies that have bought back at least 5% of their shares over the past year. To track the performance of companies created through corporate spinoffs or asset sales, there’s Guggenheim Spin-Off.

What is the appropriate benchmark?

Because these ETFs are based on an index, you can start evaluating a fund’s performance by looking at the index itself. Even though many of the indexes were built specifically for the ETF, the ETFs may have a surprising tracking error due to fluctuations from ETF trading. Some of the ETFs also have some flexibility to vary their holdings from the index.

Tom Lydon, editor of website ETFtrends.com, suggests that investors monitor the ETF for a while to make sure that it actually follows through on what the strategy dictates.

For its funds, iShares offers both tracking-error and premium/discount data on its website. Strategy-based products from iShares, a unit of BlackRock Inc. are currently based on indexes from unaffiliated providers. In an August filing with the Securities and Exchange Commission, however, iShares indicated it was looking to offer ETFs based on yet-to-be-created BlackRock Indexes. An index-to-ETF strategy is also used by Van Eck Global, Guggenheim, Russell, IndexIQ and WisdomTree.

After seeing how well the ETF tracks its own benchmark, the ETF can be benchmarked against a category average appropriate for the size (large-cap, small-cap) and style (growth, value) of the fund’s stock holdings.

How actively does the strategy rebalance?

For strategies based on relative valuation metrics, earnings forecasts or even volatility, how often the index and ETF reconstitute can be important for capturing the return on securities as they pass into the screen. Some indexes are reconstituted as frequently as monthly, others quarterly or semiannually, and some only yearly. Indexes also rebalance frequently as well. Rebalancing, unlike reconstitution, adds or subtracts shares proportionately to get back to the index’s defined rules.

Just like overall portfolio rebalancing schedules, index rebalancing should be geared toward taking advantage of opportunities in a dynamic market while also minimizing turnover. Generally, index providers test for optimal rebalancing periods when constructing a new index. Only in extraordinary circumstances are index rules reconsidered.

Consistency in the rules and taking the emotion out of the product is key to a successful index strategy, says Adam Patti, chief executive of IndexIQ.

With the frequent portfolio changes made by these ETFs, one might think they would lose some of their tax efficiency. This is not the case, so far. Like other ETFs, these funds can use shares that no longer fit the ETF’s mandate to pay institutional investors who redeem their ETF shares. That minimizes actual sales of appreciated stocks and thus limits capital-gains distributions for the ETF’s investors.

Is the strategy worth the higher cost?

This depends on where you prefer to take your costs. Most strategy-based ETFs tend to have higher expense ratios than standard index and sector ETFs, but far lower expenses than actively managed stock funds. As with any exchange-traded product, you may have to pay a commission each time you buy, whereas mutual funds generally have higher expense ratios.

For example, the $7.3 billion SPDR S&P Dividend has a 0.35% expense ratio tracking the S&P High Yield Dividend Aristocrats. That’s high when compared with the less-than 0.1% expense ratio of its broad-market cousin, SPDR S&P 500. but low compared with the $9.1 billion Fidelity Equity-Income mutual fund, which charges 0.69%.

Mr. Weinberg is an editor for The Wall Street Journal Digital Network. He can be reached by email at ari.weinberg@wsj.com .